Perhaps the most fundamental question in the field of personal finance is, “How much should I be saving for retirement?” Most pension experts will tell you “it depends,” which is true, but not very useful. Others will simply exhort you to save more, no matter how much you’re putting aside already.
I will try to offer a more concrete response by taking a historical approach. I used 79 years of data on the capital markets, inflation and wage growth to determine what savings rate would have been required for a Canadian to maintain the same standard of living in retirement. I assumed that the accumulated savings would need to be enough to provide retirement income (partly indexed to inflation) equal to 35 per cent of average salary in the five years before retirement. I also assumed the retiree doesn’t have a defined-benefit pension plan.
An income of 35 per cent of pay may not seem like a lot but in the case of most Canadians it should be enough to maintain their standard of living for life. This is because most retirees also receive income from the Canada Pension Plan (CPP) and Old Age Security (OAS), pay much less income tax after retirement and find their cash requirements usually drop significantly.
On the last point, most retirees have the advantage of no longer having to save for retirement, pay off their mortgage or support children who have now grown up. The actual percentage needed may be more than 40 per cent for some people – higher income, renters, no children – and less than 30 per cent for others.
Historical perspective
Metric
Best period ever to retire
Period
1971 to 2000
Savings rate needed
4.2%
What happened in that period
You would have just missed the bear market of 2001-2002. Moreover, interest rates were still high, which is good, and inflation was trending downward.
Metric
Worst period
Period
1946 to 1975
Savings rate needed
12.1%
What happened in that period
The bear market of 1973-74 was one of the worst ever and the cost of inflation protection was high.
Metric
Most recent result
Period
1987 to 2016
Savings rate needed
10.9%
What happened in that period
Returns were fairly good but the period ended with record-low interest rates and longer life spans; not good for annuities.
Metric
Number of periods when more than 10% was needed
Savings rate needed
11 out of 50
Metric
Average result
Savings rate needed
7.8%
THE GLOBE AND MAIL, SOURCE: FRED VETTESE
Historical perspective
Metric
Best period ever to retire
Period
1971 to 2000
Savings rate needed
4.2%
You would have just missed the bear market of 2001-2002. Moreover, interest rates were still high, which is good, and inflation was trending downward.
What happened in that period
Metric
Worst period
Period
1946 to 1975
Savings rate needed
12.1%
What happened in that period
The bear market of 1973-74 was one of the worst ever and the cost of inflation protection was high.
Metric
Most recent result
Period
1987 to 2016
Savings rate needed
10.9%
What happened in that period
Returns were fairly good but the period ended with record-low interest rates and longer life spans; not good for annuities.
Metric
Number of periods when more than 10% was needed
Savings rate needed
11 out of 50
Metric
Average result
Savings rate needed
7.8%
THE GLOBE AND MAIL, SOURCE: FRED VETTESE
Historical perspective
Savings rate needed
Metric
Period
What happened in that period
Best period ever to retire
1971 to 2000
4.2%
You would have just missed the bear market of 2001-2002. Moreover, interest rates were still high, which is good, and inflation was trending downward.
Worst period
1946 to 1975
12.1%
The bear market of 1973-74 was one of the worst ever and the cost of inflation protection was high.
Most recent result
1987 to 2016
10.9%
Returns were fairly good but the period ended with record-low interest rates and longer life spans; not good for annuities.
Number of periods when more than 10% was needed
11 out of 50
Average result
7.8%
THE GLOBE AND MAIL, SOURCE: FRED VETTESE
The first period for which I made the calculation was 1938 to 1967. It turns out that saving 8.1 per cent a year for 30 years would have been necessary for a saver in this period to achieve his retirement goal. I repeated the same calculation for all the other 30-year periods since 1967 (there are exactly 50 such periods up to 2016), and the results are shown in the accompanying bar chart.
Coming back to the original question, there is no crisp answer but history does at least provide us some useful perspective. In some periods, the required saving rate would have topped 10 per cent while in others it was less than 5 per cent. In general, saving 10 per cent a year would have been a good rule of thumb. It might still be a good rule of thumb for today’s savers but only if they believe that the immediate future will resemble one of the past 30-year periods since 1967 (any one of them really). You still need to be able to check off all of the following boxes:
- Save 10 per cent of pay every year for 30 years;
- Don’t retire too early (I assumed retirement at age 63 in the chart);
- Don’t retire with debt, including a mortgage;
- Stop supporting grownup children after retirement;
- Stay fully invested at all times before retirement (I assumed 30 per cent of your portfolio would be invested in U.S. equities, 30 per cent in Canadian equities and 40 per cent in long-term bonds);
- Keep your investment fees low (I assumed total annual fees of 0.8 per cent (80 basis points).
Admittedly, that’s a lot of boxes, but believe it or not, that is the easy part. The one factor outside of your control is the worry that the future could be fundamentally different than the past. There is at least one reason to think it might be – demographics.
With an aging population, our future interest rates, inflation and investment returns may resemble Japan’s stubbornly low levels over the past 25 years more than any past period in North America. (This phenomenon is known as “low for long”). If so, the future would be appreciably worse for savers than anything Canadians have experienced since the Great Depression. On the basis of “low for long,” my calculations show that you might have to save as much as 20 per cent a year for 30 years to retire well.
Canadians dreaming of retirement are therefore left with a difficult choice. On the one hand, you might believe that if we could cope with global oil-price shocks, a massive run-up in inflation and terrorism then we should also be able to handle whatever the future holds in store. In that case, investing 10 per cent a year will suffice and could even be on the high side.
On the other hand, you might subscribe to the view that we are on the brink of a new demographic-fuelled era of “low for long.” In this case, you should either start saving a lot more than 10 per cent a year or else reconcile yourself to working until you’re 70.
Frederick Vettese is an actuary and author of the book Retirement Income for Life: Getting More without Saving More.
